The S&P 500's 5 Most Hated Stocks

January was anything but a banner month for the broad-based S&P 500 (SNPINDEX: ^GSPC) , with the iconic index turning in one of its worst months in years. Despite this minor victory for short-sellers, it's been a relatively straight shot upward for the index over the past five years.

A number of factors have contributed to the ongoing strength behind the rally in the S&P 500. The U.S. economy delivered 4.1% GDP growth in the third quarter, and preliminary estimates for the fourth quarter show still-robust growth of 3.2%. The manufacturing sector is also showing a healthy expansion, with the Chicago PMI last week coming in with a reading of 59.6 (anything more than 50 signals expansion). The unemployment rate has dropped to 6.7%, its lowest reading since July 2008. In all respects, the nation's economy is giving investors every reason to believe this economic rebound will continue.

But, as a growing number of skeptics will tell you, not everything is as it appears.

Last month, I outlined three ways that U.S. consumers are being tricked into believing the economy is perfectly healthy. While I encourage you to read the more in-depth discussion, the three factors that are masking slower growth are: a falling labor-participation rate, which makes the unemployment rate seem rosier than it actually is; the continuation of quantitative easing, which is artificially keeping interest rates low and spoiling the U.S. consumer; and a dramatic increase in the number of share buybacks and cost-cutting maneuvers used to mask a lack of top-line growth.

With these concerns in mind, I suggest we do what we do every month: take a deeper dive into the S&P 500's five most hated stocks. Why, you ask? Because this way we can better understand what characteristics, if any, attract short-sellers so that we can avoid buying similar companies in the future.

I've actually lost count of how many months in a row now Cliffs Natural Resources has been the most short-sold company in the S&P 500, but rest assured, it handily held its No. 1 position again in January after a dismal monthly performance. The case against Cliffs Natural Resources remains the same as it's been in previous months: Iron ore prices are weak, and China's manufacturing demand is shrinking, which could reduce its commodity-based demand even further. With Cliffs slashing its dividend last year by roughly three-quarters and not exactly knowing when prices or demand will improve, investors are using this uncertainty to load up on bets against the iron-ore and metallurgical-coal miner.

Is this short interest warranted?

I'm a bit torn here, because there's absolutely no reason short-sellers shouldn't be skeptical of Cliffs, given its sizable recent dividend cut and relatively uncertain near-term steel demand. Then again, iron ore prices have staged a sizable rebound from their low point in 2013, and China's commodity demand hasn't tapered off anywhere near as badly as expected. In addition, last week private-equity investment firm Casablanca Capital took a 5.2% stake in Cliffs, sending a letter to management calling for changes, including a spinoff of its Bloom Lake and international assets, as well as a conversion of its U.S. assets into a master limited partnership, which would help the company from a tax perspective and boost shareholder dividends. This activist investor interest, coupled with Cliffs' single-digit forward P/E, make it an attractive company at these levels.

GameStop Why are investors shorting GameStop?

It's pretty easy to dislike the gaming sector in general, because the timeline for development for new video-game consoles only seems to get longer between each next-generation system. Meanwhile, most games are moving toward a digital format. Also, GameStop's brick-and-mortar presence gives it less flexibility than online game companies, which have lowered overhead costs. Finally, there's the simple fact that the introduction of the PlayStation 4 and Xbox One in 2013 will make comparable-store sales practically impossible to top over the coming year. In other words, it's a "buy the rumor, sell the news" type of scenario.

Source: GameStop.

Is this short interest warranted?

Based on GameStop's miserable holiday sales update, I'd say short-sellers have been prescient in their call. In mid-January GameStop noted that global sales jumped 9.3% to $3.15 billion for the holiday season, but its growth was offset by a big reduction in Xbox 360 and PlayStation 3 sales (as if this were somehow unforeseen?). Ultimately, GameStop lowered its fourth-quarter earnings-per-share guidance to a range of $1.85-$1.95 from prior expectations of $1.97-$2.14, and the stock tanked. While GameStop will have a downside buffer due to its strong cash flow and high margins from reselling used games, it will find same-store comparisons increasingly difficult over the coming years and is unlikely to see another next-generation console boost for a number of years. It may be time for optimists to begin heading for the exits.

U.S. SteelWhy are investors shorting U.S. Steel?

The bet against U.S. Steel has been a bet against an increase in steel prices and demand domestically and from China. Although this has been a trend we've witnessed across much of the sector, it has hit U.S. Steel particularly hard because the company carries a higher percentage of debt relative to equity than most of its peers. Another factor that has really sacked U.S. Steel, at least in the past couple of quarters, has been a number of one-time charges that have resulted in exorbitant noncash EPS losses.

Is this short interest warranted?

After a near-doubling in the share price since May, short-sellers have every right to be skeptical of U.S. Steel. The steelmaker's fourth-quarter results on Jan. 27 delivered a much-welcomed adjusted EPS profit of $0.27, compared to a hefty year-ago loss as demand and pricing for a number of its products improved and its expenses dipped. However, looking ahead, the company's critical tubular-products segment is expected to see pricing weakness in the first quarter, and it's still dealing with $3.3 billion in net debt, which may make it difficult for U.S. Steel to make strategic moves, should the opportunity or need arise. A forward P/E of 12 may not seem expensive, but when you're dealing with minimal top-line growth and a lot of debt, it's a good recipe for attracting short-sellers.

ADT Why are investors shorting ADT?

As we saw last month, short interest in electronic security solutions provider ADT has been rising precipitously in the past couple of months, but until recently it had been a bit of a struggle to figure out why. The prevailing thesis pessimists were relying on was the company's weak top-line growth and hefty share buybacks that masked weaker operational EPS and margin growth. Add in a significant amount of debt, and short-sellers have been betting on ADT to tumble.

Is this short interest warranted?

Based on ADT's first-quarter results, I'd say this short interest is unequivocally deserved. For the quarter, reported late last week, ADT saw a revenue increase of just 4% as EPS dipped 11% despite the company's best efforts to buy back shares. The long-term problem for ADT, which doesn't have a visible solution at present, is how it will lower its subscriber acquisition costs and retain existing customers without having to spend a boatload of money. With $4.4 billion in debt, it's not as if ADT has a lot of flexibility, in my view. Pessimists have every reason to sink their teeth into ADT here.

Telecom service provider Frontier Communications has actually seen a minor retracement in short interest over the past couple of months. Pessimists have been generally sticking to Frontier because of its ill-timed purchase of landline assets from Verizon a few years back, which left it with a hefty amount of debt and an ongoing exodus of landline customers who no longer need a home phone as cellphone service improves into rural areas. These short-sellers are counting on a possible third dividend cut for Frontier in order to save capital and an ongoing drop in high-margin landline customers.

Is this short interest warranted?

While Frontier has done little to slow the attrition of landline customers -- and it's not as if much can be done -- it has still generated significant cash flow and healthy margins from these customers, which is allowing it to reduce debt and pay out an 8% yield. Generally speaking, short-sellers don't like high-yielding companies as they can be painful in the pocketbooks come dividend time, since short-sellers owe what currently amounts to 8% per year in stipends. With Frontier confident that it can maintain cash flow to pay down its debt and continue to generate $0.40 in annual dividends, I see few telltale downside catalysts.

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Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

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